Chapter 8 - Stock Valuation

• 2005, Pearson Prentice Hall

Security Valuation 
In general, the intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return.

Preferred Stock
A hybrid security:  It¶s like common stock - no fixed maturity.

Preferred Stock
A hybrid security:  It¶s like common stock - no fixed maturity. 
Technically, it¶s part of equity capital.

Preferred Stock
A hybrid security:  It¶s like common stock - no fixed maturity. 
Technically, it¶s part of equity capital. 

It¶s like debt - preferred dividends are fixed.

Preferred Stock
A hybrid security:  It¶s like common stock - no fixed maturity. 
Technically, it¶s part of equity capital. 

It¶s like debt - preferred dividends are fixed. 
Missing a preferred dividend does not constitute default, but preferred dividends are cumulative.

Preferred Stock 
Usually sold for $25, $50, or $100 per share.  Dividends are fixed either as a dollar amount or as a percentage of par value.  Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share. 
$4.125 is the fixed, annual dividend per

Preferred Stock Features 
Firms may have multiple classes of preferreds, each with different features.  Priority: lower than debt, higher than common stock.  Cumulative feature: all past unpaid preferred stock dividends must be paid before any common stock dividends are declared.

Preferred Stock Features 
Protective provisions are common.  Convertibility: many preferreds are convertible into common shares.  Adjustable rate preferreds have dividends tied to interest rates.  Participation: some (very few) preferreds have dividends tied to the firm¶s earnings.

Preferred Stock Features 
PIK Preferred: Pay-in-kind preferred stocks pay additional preferred shares to investors rather than cash dividends.  Retirement: Most preferreds are callable, and many include a sinking fund provision to set cash aside for the purpose of retiring preferred shares.

Preferred Stock Valuation 
A preferred stock can usually be valued like a perpetuity:

Preferred Stock Valuation 
A preferred stock can usually be valued like a perpetuity:

Vps =

D k ps

Example: 
Xerox preferred pays an 8.25% dividend on a $50 par value.  Suppose our required rate of return on Xerox preferred is 9.5%.

Example: 
Xerox preferred pays an 8.25% dividend on a $50 par value.  Suppose our required rate of return on Xerox preferred is 9.5%.

Vps =

4.125 .095

=

Example: 
Xerox preferred pays an 8.25% dividend on a $50 par value.  Suppose our required rate of return on Xerox preferred is 9.5%.

Vps =

4.125 .095

=

$43.42

Expected Rate of Return on Preferred 
Just adjust the valuation model:

Expected Rate of Return on Preferred 
Just adjust the valuation model:

kps =

D Po

Example 
If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is:

Example 
If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is:

kps

D = Po

4.125 = = 40

Example 
If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is:

kps

D = Po

4.125 = = .1031 40

The Financial Pages:
Preferred Stocks
52 weeks Yld Vol Hi Lo Sym Div % PE 100s Close 2788 2506 GenMotor pfG 2.28 8.9 « 86 25 53 

Dividend: $2.28 on $25 par value = 9.12% dividend rate.  Expected return: 2.28 / 25.53 = 8.9%.

Common Stock 
Is a variable-income security. 
Dividends may be increased or decreased, depending on earnings. 

Represents equity or ownership.  Includes voting rights.  Limited liability: liability is limited to amount of owners¶ investment.  Priority: lower than debt and preferred.

Common Stock Characteristics 
Claim on Income - a stockholder has a claim on the firm¶s residual income.  Claim on Assets - a stockholder has a residual claim on the firm¶s assets in case of liquidation.  Preemptive Rights - stockholders may share proportionally in any new stock issues.  Voting Rights - right to vote for the firm¶s board of directors.

Common Stock Valuation
(Single Holding Period)  You expect XYZ stock to pay a $5.50 dividend at the end of the year. The stock price is expected to be $120 at that time.  If you require a 15% rate of return, what would you pay for the stock now?

Common Stock Valuation
(Single Holding Period)  You expect XYZ stock to pay a $5.50 dividend at the end of the year. The stock price is expected to be $120 at that time.  If you require a 15% rate of return, what would you pay for the stock now?

? 0

5.50 + 120 1

Common Stock Valuation
(Single Holding Period)

Solution: Vcs = (5.50/1.15) + (120/1.15) = 4.783 = $109.13 + 104.348

Common Stock Valuation
(Single Holding Period)

Financial Calculator solution: P/Y =1, I = 15, n=1, FV= 125.50 solve: PV = -109.13 or: P/Y =1, I = 15, n=1, FV= 120, PMT = 5.50 solve: PV = -109.13

The Financial Pages:
Common Stocks
52 weeks Yld Vol Net Hi Lo Sym Div % PE 100s Hi Lo Close Chg 135 80 IBM .52 .5 21 142349 99 93 9496 -343 82 18 CiscoSys -113 « 47 1189057 21 19 2025

Common Stock Valuation
(Multiple Holding Periods) 

Constant Growth Model 
Assumes common stock dividends will grow at a constant rate into the future.

Common Stock Valuation
(Multiple Holding Periods) 

Constant Growth Model 
Assumes common stock dividends will grow at a constant rate into the future.

Vcs =

D1 kcs - g

Constant Growth Model 
Assumes common stock dividends will grow at a constant rate into the future.

Constant Growth Model

D1  Assumes common stock dividends will grow at a constant rate into the future.

Vcs =

kcs - g

Constant Growth Model 
Assumes common stock dividends will D1 grow at a constant rate into the future.

Vcs =

kcs - g 

D1 = the dividend at the end of period 1.  kcs = the required return on the common

Example 
XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

Example 
XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

D0 = $5, so D1 = 5 (1.10) = $5.50

Example 
XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

Vcs =

Example 
XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

Vcs =

D1 kcs - g

=

Example 
XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

Vcs =

D1 kcs - g

=

5.50 .15 - .10

=

Example 
XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

Vcs =

D1 kcs - g

=

5.50 .15 - .10

= $110

Expected Return on Common Stock 
Just adjust the valuation model

Expected Return on Common Stock 
Just adjust the valuation model

D Vcs = kcs - g

Expected Return on Common Stock 
Just adjust the valuation model

D Vcs = kcs - g

k =

(

D1 Vcs

) + g

Expected Return on Common Stock 
Just adjust the valuation model

D Vcs = kcs - g

k =

(

D1 Po

) + g

Example 
We know a stock will pay a $3.00 dividend at time 1, has a price of $27 and an expected growth rate of 5%.

Example 
We know a stock will pay a $3.00 dividend at time 1, has a price of $27 and an expected growth rate of 5%.

kcs =

(

D1 Po

) + g

Example 
We know a stock will pay a $3.00 dividend at time 1, has a price of $27 and an expected growth rate of 5%.

kcs = kcs = (

(

D1 Po

) + g
=

3.00 27

) + .05

Example 
We know a stock will pay a $3.00 dividend at time 1, has a price of $27 and an expected growth rate of 5%.

kcs = kcs = (

(

D1 Po

) + g
= 16.11%

3.00 27

) + .05

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